The Monetary System
The Department of the Treasury, or the Treasury for short, basically handles the finances of the United States’ government.
Banks are institutions where people and businesses deposit money in order to earn interest and borrow money in order to fund major asset purchases that help them grow financially. Banks make money from the interest people and businesses pay on money the bank lent them.
The central bank in the United States is called the Federal Reserve, or the Fed for short. Think of the Fed as a bank for the government and other banks.
All banks have to keep a certain amount (ex.10%) of their money at the Fed. This money is used to cover withdrawals by people and businesses who keep money at the banks and checks written against the accounts at those banks. They’re basically required to keep this money stashed away to cover people withdrawing their money on any given day.
So when you write someone a check and they deposit it into their bank account, the money gets traded from one bank to another. If it’s the same bank, the bank just keeps the money and records electronically that it belongs to someone else instead of you.
The Treasury also keeps an account at the Fed, which all government spending is paid out of. Just like when you write a check, when the government writes a check, the Fed transfers the money from the government’s account into the account of whoever they payed. The Treasury also makes deposits into their account at the Fed with money they collect from taxes (money they make) or from the sale of securities (money they borrow).
Perhaps the most important responsibilities of the Fed are to maintain the stability of the banking and financial systems. Because these are tied so closely to the economy, they essentially try to maintain a sense of balance in the economy.
They have 3 ways of doing this:
1) Open Market Operations
2) Changing Reserve Requirements
3) Changing the Discount Rate
Open market operations means the Fed buys or sells government securities (which originally come from the Treasury) in the secondary market (from/to banks and other institutions) to add or drain banking system reserves. If they buy securities, there is more money out there for banks to lend. If they sell securities to banks there is less money out there for banks to lend.
When the Fed changes the reserve requirements, they change the amounts that banks are required to have deposited with the Fed. If they increase this, there is less money for the banks to lend out, which means there is less money available for people and businesses to borrow for growth. If they decrease the requirements, there is more money for the banks to lend out, which means there is more money available for people and businesses to borrow for growth.
The discount rate is the rate the Fed charges banks that borrow money from it. Banks borrow money from the Fed when they fall below their required reserve amounts and they don’t have additional money available to make up the difference (because they’ve lent it out).
By raising the discount rate, the Fed makes borrowing more expensive for banks, who then turn around and raise their interest rates, making it more expensive for people and businesses to borrow money. By lowering the discount rate, the Fed makes borrowing less expensive for banks, who then turn around and lower their interest rates, making it less expensive for people and businesses to borrow money.
The Treasury also has the ability to influence the financial system and the economy by “printing money.” This basically means that they print up government securities (promises to repay money) and sell them to the Fed and other institutions in exchange for money.
As you can imagine, there are benefits and shortcomings to having this type of monetary system, some of which we will go over in a future lesson.
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